“Moo”-ving Away from Omegas: Seventh Circuit Opens the Barn Door for Use of Constructive Trusts as a Preference Defense

Contributed by Ginger Ellison.
Distinguishing itself from the Sixth Circuit’s holding in In re Omegas Group, Inc., in In re Mississippi Valley Livestock, Inc., the Seventh Circuit recently held that, under some circumstances, the bankruptcy court may impose a constructive trust to find that prepetition funds transferred by the debtor never constituted property of the debtor.
Background & Issues
The debtor, Mississippi Valley Livestock, housed — but did not own or retain the option to buy — cattle from multiple ranchers, including J&R Farms.  The debtor acted as the middleman in cattle sales; it housed ranchers’ cattle that were ready for sale, sold the cattle into the market, collected the proceeds from the sale, deposited those proceeds into its general operating account, and then paid the various ranchers the respective amounts owed to them from funds on deposit in its operating account.   
In early March through early April of 2007, Mississippi Valley sent J&R Farms nearly $900,000 representing completed sales.  In May 2007, several creditors filed an involuntary petition for relief against Mississippi Valley under chapter 7 of the Bankruptcy Code.  The trustee sought to recover the funds Mississippi Valley transferred to J&R Farms as preferences under section 547(b) of the Bankruptcy Code.
J&R Farms, however, argued that the payments could not constitute preferential transfers because the debtor essentially acted as a conduit, and, therefore, the transferred funds did not constitute “an interest of the debtor in property” as required under section 547(b).  The issue came down to whether a constructive trust might be imposed on the transferred funds, thereby qualifying them as property of J&R Farms.  The court focused its analysis on three questions:

1)     Did Mississippi Valley hold J&R Farms’ cattle in bailment? 

2)     Is it possible to impose a constructive trust in bankruptcy? 

3)     Can the payments made during the preference period be traced to the proceeds of the sales of J&R Farms’ cattle? 

The Seventh Circuit answered each question in turn.
Bailment May Exist where a Seller Acts as a Supplier’s Agent
In arguing that the debtor had the requisite property interest in the funds, the trustee contended that Mississippi Valley’s estate had an interest in the transferred funds because they were commingled with the company’s general operating account.  In contrast, J&R Farms maintained that Mississippi Valley held the cattle sale proceeds in bailment, and hence, the proceeds were never part of the debtor’s estate. 
The Seventh Circuit turned to its 1903 decision, In re Galt, in finding that the key distinguishing feature of a bailment is that the sender (here, J&R Farms) has a right to compel a return of the goods sent, and that the receiver (here, Mississippi Valley) does not have the option to pay for the goods in money.  Mississippi Valley never had an ownership interest in, nor a right to purchase, the supplier’s cattle, agreed to pay J&R Farms immediately following the sales, and disposed of the cattle as J&R Farms directed.  Based on these facts, the Seventh Circuit found that Mississippi Valley behaved as J&R Farms’ agent and, therefore, a prepetition bailment existed between J&R Farms and Mississippi Valley.
In the Seventh Circuit, Courts May Sparingly Use Constructive Trusts as Remedies in Bankruptcy
Although the court found that a bailment existed, its analysis was not complete.  Mississippi Valley’s transfer of money, a fungible asset, as opposed to cattle, complicated matters.  To hold that J&R had an interest in the funds transferred, the court had to find a link between J&R’s cattle and the funds that Mississippi Valley transferred to J&R — and the only way to do so was to impose a constructive trust over the funds in favor of J&R.  If the remedy of a constructive trust were feasible, J&R would triumph over the trustee because “[j]ust as the assets of a conventional trust do not enter the bankruptcy estate when the bankrupt person is the trustee, . . . the assets of a constructive trust do not either.”
The Seventh Circuit acknowledged that other courts have rejected the view that constructive trusts may properly exist in bankruptcy.  Specifically, the Sixth Circuit held in its much-cited Omegas case that the constructive trust, in privileging some creditors over others, is fundamentally at odds with the Bankruptcy Code’s objectives, and, therefore, bankruptcy courts could not impose constructive trusts except in very narrow circumstances. Though the Seventh Circuit in Mississippi Valley recognized that the remedy of a constructive trust could subvert the Bankruptcy Code’s distribution scheme, it held that the constructive trust has a place in bankruptcy — provided that courts use it sparingly and that state law polices any abuses of the remedy.
In deciding whether the estate would be unjustly enriched by retaining the claimant’s property, the court emphasized that the debtor’s creditors — in other words, the bankruptcy estate — could feasibly gain an equitable interest even though the debtor itself had no such interest.  This is because the issue is not whether the debtor had a legitimate ownership interest in the disputed property; instead, it is whether the debtor was holding the property for the benefit of another.  This distinction is crucial, for if the court restricted its analysis to the statutory scope of the debtor’s property, the debtor’s creditors would always yield to a claimant who had a valid restitution claim against the debtor.  Viewing the constructive trust as a remedy for a restitution claim against the estate allows the estate to invoke certain defenses that are unavailable to the debtor.
More Information Needed to Apply the Lowest Intermediate Balance Rule in Tracing the Proceeds
In bankruptcy, a restitution claimant seeking the remedy of a constructive trust must, at a minimum, prove its interest in specific property presently in the estate’s possession. In Mississippi Valley, the funds were drawn from a commingled account.  As a result, the court held that the lowest-intermediate balance rule would determine the extent of J&R’s interest in the account.  Pursuant to this rule, if the amount on deposit in the commingled fund has at all times equaled or exceeded the amount of the trust, the trust’s funds will be returned to their full amount. To the extent that the lowest intermediate balance dips below the amount of the proceeds deposited pursuant to the trust, however, the claimant’s claim will be abated accordingly.
Absent information about the lowest intermediate balance of Mississippi Valley’s comingled account, the court could not determine whether the transferred funds in their entirety were properly impressed with the trust.  As a result, J&R had not demonstrated that the transferred funds were its property, and the court could not determine whether they were “an interest of the debtor in property” as required to support the trustee’s preference action under section 547(b).  Hence, the court remanded the case for further proceedings.
In departing from the Sixth Circuit’s holding in Omegas, the court in Mississippi Valley Livestock gave creditors in the Seventh Circuit slightly more flexibility in seeking the remedy of a constructive trust.  The court refused to endorse the Sixth Circuit’s more severe restrictions on the availability of the constructive trust in bankruptcy; however, by cautioning lower courts to exercise the remedy sparingly and remanding the case to ensure that the funds were traceable, the Seventh Circuit reinforced the Sixth Circuit’s view that this remedy is only to be used with care.  Seventh Circuit creditors seeking restitution in the bankruptcy context will not be as strictly limited in bringing forward arguments supporting the imposition of a constructive trust as those in the Sixth Circuit; as a result, they may have more opportunity to gain priority access to property of the estate and a better defense to preference actions.  Nevertheless, they continue to face an uphill battle in meeting all the requirements of a constructive trust.